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seth klarman: "but not yet" - the coming crisis

st. augustine is famous for having prayed: "lord, make me chaste... but not yet." seth klarman - a famously successful value investor - evokes the quote without referencing augustine, and says that postponing the pain of what we need to do will lead to a crisis. my comments follow klarman's [emphases added by me].

Seth Klarman & Baupost Group's 2010 Letter Excerpt

"Two problems are upon us at once: short-term stimulus that is unaffordable over the long run and runaway entitlements that must be reined in. But restoring fiscal sanity will be bad for the economy and financial markets. What Treasury official or politician would want the cash spigot turned off before a recovery is certain? Recipients of government handouts – a large percentage of the population – would grumble at the termination of policies that offer them outsized benefits. So prepare for a chorus of "but not yet.” One already sees this in editorials and commentaries, such as the ones saying it's time to close down bankrupt Fannie Mae and Freddie Mac, but not yet, because doing so would harm the still-weak housing market. There will never be a good time to end housing support programs, reverse quantitative easing policies, end fiscal stimulus, or reduce massive budget deficits – because doing so will restrict growth and depress share prices. Nor will there be a good time to cut entitlement programs or to solve Social Security or Medicare underfunding. All will agree the stimulus cannot go on forever, that excessive entitlements must be reined in, “but not yet."

The financial collapse of 2008 highlighted our national predicament. The sudden decline in consumer activity that followed the plunges in the housing and stock markets represented a reasonable – indeed a desirable – response to over-indebtedness. Yet the federal government saw this well-advised retrenchment as cataclysmic, because the national economy had grown dependent on our living beyond our means. The imagination of our financial leaders remains so shallow that their response to a crisis caused by over-leverage and excess has been to recreate, as nearly as possible, the conditions that fomented it, as if the events of 2008 were a rogue wave of financial woe that can never recur. It is only in Fantasyland that the solution to vastly excessive debt is more debt and the answer to over-consumption is less saving and more spending. Worse still, we have yet to see a serious assessment by policymakers of the causes of the 2008 financial market and economic collapses so that we might take action to ward off a repeat performance. The government’s knee-jerk response to contraction was to prop up economic activity by any and every means possible; the hole in consumer activity had to be materially repaired on the government tab. While Treasury Secretary Timothy Geithner ingenuously professes a belief that the U.S. will never lose its AAA rating, Moody's recently warned that, absent a change, a downgrading could be just around the comer. Or, in the words of David Letterman, "I heard the U.S. debt may now lose its triple-A rating. And I said to myself, well who cares what the auto club thinks."

Most of us learned about the Great Depression from our parents or grandparents who developed a "Depression mentality," by which for decades people shunned leverage, embraced thrift, and thought twice before quitting their secure jobs to join risky ventures. By bailing out the economy rather than allowing the pain of the economic and market collapses to be felt, the government has endowed our generation with a "really-bad-couple-of-weeks-mentality": no lasting lessons are learned; the government endlessly intervenes in the economy, and, ironically, the first thing to strongly rebound from the 2008 collapse isn't jobs or economic activity but speculation.

Benjamin Graham's margin-of-safety concept – to invest at a sufficient discount so that even bad luck or the vicissitudes of the business cycle won't derail an investment – is applicable to the economy as a whole. Bridges intended for ten-ton trucks are overbuilt by engineers to hold vehicles of 30 tons. Responsible investors assume their best judgments will sometimes go awry and insist on bargain purchases that allow room for error. Likewise, an economy built with no margin of safety will eventually implode. Governments that run huge deficits, promise entitlements that will be next-to impossible to deliver, and depend on the beneficence of foreigners to stay afloat inevitably must collapse – perhaps not imminently but eventually, as Greece and Ireland have recently discovered.

It is clear, both in the financial markets and in government policy, that no long-term lessons have been drawn from the events of 2008. A friend recently posited that adversity is valuable not for what it teaches but for what it reveals. The current episode of financial adversity reveals some unpleasant truths about the character and will of our country and its leaders, and offers an unpleasant picture of the future that awaits, unless we quickly find a way to change course.

jk: it is clear that "the right time" to take the pain of correcting our accumulated fiscal problems will never arrive. there will always be a reason to say "but not yet" to meaningful action. instead there will be a lot of lip service paid, and symbolic gestures made, without significant effect on the underlying issues. only a crisis beyond the capacities of gov't intervention will cause true change. the questions then are: 1. what will be the nature of the coming crisis? can we predict even its vague outlines? 2: when will it come? will there be clear warnings? and 3. what can we do to prepare? i want to address explicitly the first of these questions, mention some glimmerings about the second, and leave implicit thoughts about the third.

bill fleckenstein has for some time been saying that what is coming is "a funding crisis," which may or may not also take the form of "a currency crisis." the compounding nature of the federal debt, combined with the unprecedentedly high deficits, surely makes these good candidates for a real crisis. [to quote herb stein's law: "if something cannot go on forever, it will stop."] what the u.s. gov't did with the bank bailouts was identical to what happened with a bit more clarity in ireland - the banks were overleveraged and effectively bankrupt, and they were rescued by having their obligations taken on by the central government. ireland, to its misfortune at least in the short term, cannot print money to "fix" this problem. the u.s. can. so ireland went into crisis immediately and obviously once it took on the bank obligations. the u.s. has postponed its crisis with the aid of the fed's printing press.

but the fed has announced it will cease its q.e. treasury-bond-buying in july. and it is under political pressure to live up this intention. so what would happen if the u.s. treasury gave a bond auction and nobody came?

not long ago, "bond king" bill gross announced he had sold all his u.s. gov't debt. this week, warren buffett said to avoid long term u.s. dollar debt, because the dollar would depreciate. ray dalio, in a pair of interviews a few weeks ago, said that commodities, and - especially - gold, were underrepresented in conventional portfolios. the chinese ceased adding to their u.s. treasury holdings some time ago - they'd rather buy commodities and commodity producers. the japanese are suddenly unable to generate the dollar revenues they've habitually recycled into treasuries, and perhaps will even need to repatriate capital. u.s. "friendly" oil exporters, such as the saudis, have discovered a need to spend more of their revenues on benefits for their restless populations, including subsidies to counteract the spiraling costs of food. so they will not be buying so many treasuries, either. again, what if they gave a bond auction and nobody came?

one potential bond buyer i haven't mentioned is the domestic saver. savings rates have crept up a bit from the negative rates that existed during the housing-as-atm bubble. could the savings rate rise enough for the deficit to be funded domestically? and, even if this unlikely eventuality came to pass, wouldn't that imply a collapse in domestic demand?

so one funding crisis scenario involves a sudden skyrocketing of long rates as the fed steps back from qe. this would be accompanied by collapsing equity and commodity prices, products of a rapid and forced deleveraging, and another "deflation scare." remember the deflation scare of 2002? that was the justification for greenspan lowering rates to the floor and blowing up the housing bubble. this time collapsing asset prices will be the justification for, and provide political cover for, qe3.

then we get flight out of the dollar. i.e. the funding crisis precipitates the currency crisis.

ray dalio, in the interviews i referenced above, said he expected a currency realignment, perhaps as early as 2012. dollar flight would create a dilemma for countries with currencies pegged to the dollar, most notably china. china has been experiencing its own housing bubble, as well as generalized wage and price inflation which it has been unable or unwilling to really control. a sharp drop in the dollar [measured against commodities] would provide the push for china to allow its currency to appreciate. this would mean giving up some of its export market potential in the u.s., i.e. chinese goods would cost more priced in dollars. but the u.s. is already becoming a diminished market for mass consumption goods. the so-called "hourglass economy" in the u.s. continues to squeeze mass consumption, while leaving the high end consumption market in better shape. look at the latest charts at the consumer metrics institute website- discretionary consumption has been shrinking for the past year and a quarter.

this means the u.s. mass consumption market is a diminishing target in any event: giving it up implies less and less of a sacrifice. further, an upward revaluation of the yuan would directly relieve some of china's inflationary pressures by lowering the chinese price of commodities. i think this is the dynamic that underlies dalio's prediction.

would the fed really step in? could they refrain? and could they refrain with 2012 an election year, with the fed traditionally wanting to be seen as outside the political process? which would constitute more "meddling" in the political process: stepping in to "save" the economy from an asset-value collapse and debt-deflation? or standing aside and letting high rates and collapsing asset prices decimate the economy? i think the judgement will be that the economy is "not yet" ready for such strong medicine. like a junky addicted to heroin but cut off from the drug, the economy will be in debt-withdrawal, and fed's qe3 will play the role of the methadone substitute.

so the funding crisis leads to a currency crisis. the dollar depreciates sharply against commodities AND em currencies which are finally allowed to rise against the dollar. imports to the u.s. become much more expensive: toaster ovens and such, gadgets fabricated in china, rise in price but more importantly internationally traded commodities, most prominantly food and oil, spike in u.s. dollar terms. it will look like really bad stagflation if we're lucky, like an inflationary depression if we're not so lucky.

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